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Eyeing Higher Costs in CDS Exchanges

Many of the hedge fund industry's chief prime brokers, including Bank of America, Deutsche Bank, Goldman Sachs and J.P. Morgan Chase, are warning their biggest hedge fund clients that trading costs for credit default swaps will go up significantly if the government requires the trades to go through central clearing houses, according to sources familiar with the matter.

Ironically, most hedges funds may not mind.

Credit default swaps are a kind of derivative that allow trades on specific risks, like a bond or debt default. They are popular investments for hedge funds. Historically CDS instruments have been traded in over-the-counter markets, where banks act as intermediaries for the hedge funds to settle on their contracts in exchange for a percentage basis point spread.

But the past year has seen trillions of dollars in credit-default swap trades cleared and settled by two new clearing houses, the Intercontinental Exchange and The Chicago Mercantile Exchange.

And that trend may continue. Part of President Obama's greater financial-reform package is a provision that would require all swap trades to go through central clearing on an exchange. That bill is presently stuck in the Senate.

In addition, the Securities and Exchange Commission is pushing for Congress to allow securities-based swaps to be regulated as strongly as the security that underlies the swap. And such regulation would require a centralized exchange.

"A centralized exchange makes sense for the more standardized derivatives, " says Jeremy Smith, Chief Strategy Officer for SecondMarket, the largest centralized marketplace and auction platform for illiquid assets whose participants collectively manage over $1 trillion in assets available for investment. "However, when it comes to the customized products it's going to take a bit more calculus to figure out the right way to handle them. Maybe there's a solution and maybe there isn't. Legislation is not a bad thing. Bad legislation is a bad thing."

Some believe a centralized exchange will come at a high cost for investors. There would likely be stricter margin and collateral requirements; contributions to million-dollar guarantee funds required by the clearing houses; and processing fees. Robert Sloan, Managing Partner of $60 billion S3 Partners, a New York-based non-propriety prime broker which counts 3% of the entire hedge fund industry as its clients, doesn't think the total tally will end up being a drop in the bucket. "The costs of trading are due to run up dramatically. It could even be as high as 50 basis points," he says.

But not all the players are so sure. BNP Paribas, for example, has started talks internally but thinks it's too early to determine all the impacts including the cost impact from the proposed legislation. "Right now we are watching the legislative debate closely, and our legal experts are active in this and other dialogues concerning the CDS markets and CDS centralized clearing. We will be keenly following this very important topic with our internal and external partners, " says Samuel Hocking, Global Head of Brokerage Sales at BNP Paribas.

Hocking added that hedge funds generally may be willing to go through exchanges, despite higher costs, because "it's more efficient and there's more transparency … while it might be more expensive to set up one clearing house, over time, if the history of other exchanges is a judge, then costs will go down in the future.”

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